My guest today is Thomas Gilovich, an American psychologist who is the Irene Blecker Rosenfeld Professor of Psychology at Cornell University. He has conducted research in social psychology, decision making, behavioral economics, and has written popular books on these subjects.
In this episode of Trend Following Radio we discuss:
How his world dovetailed into money and markets
Basketball, streak shooting, and the “hot hand”
Randomness and the clustering illusion
The missing Malaysian Airlines flight and probability
The reluctance to accept a probabilistic view of the world
Politics, predictions, and probabilities
People who see the world in black and white
Drawing conclusions from incomplete and unrepresentative evidence, and how to avoid that folly
The position of the devil’s advocate, and the importance of that role
Gilovich’s response to the media’s talking heads, and their often black and white opinions
Behavioral economics vs. traditional economics
When people do the wrong thing because the public demands it
Bill James and the closer
Instinct vs. considered judgment and test taking
Irrationality in financial markets and bubbles
Loss aversion
Why you don’t need to be better than the market
Listen to this episode:
Listen to this podcast on iTunes. (Please leave a rating!)
Mike. Are you ever returning to San Diego? How is yoga and world travels? Here is a quote from a guy that has sold millions of books and truly just about sums up the masses and the psychology of losing: “If you made money in 2008, you did something wrong” from Ben Stein. Ok, thought you would get a kick out of it.
The market isn’t always right. It’s merely the market.
Mass appeal is not always better than doing something that matters.
Increasing shareholder value is not the primary purpose of a corporation.
News with a lot of clicks isn’t always important news.
Selling out to get popular is selling yourself short.
Lowering the price at the expense of sustainability is a fool’s game.
Only producing tools that don’t need an instruction manual takes power away from those prepared to learn how to use powerful tools. And it’s okay to write a book that some people won’t finish, or a video that some don’t understand.
Giving people what they want isn’t always what they want.
Curators create value. We need more curators, and not from the usual places.
Creating and reinforcing cultural standards and institutions that elevate us is more urgent than ever.
We write history about people who were brave enough to lead, not those that figured out how to pander to the crowd.
Elites aren’t defined by birth or wealth, they are people with a project, individuals who want to do work they believe in, folks seeking to make an impact. Averaging down everything we do so that it becomes cheap and ubiquitous and palatable to all is a hollow goal.
My guest today is Daniel Kahneman, the second Nobel Prize winner to appear on this podcast. Kahneman is an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics, for which he was awarded the 2002 Nobel Memorial Prize in Economic Sciences.
The topic is behavioral psychology.
In this episode of Trend Following Radio we discuss:
Kahneman’s beginnings, and how he came to realize he was looking at the world from a different vantage point than most
How Kahneman’s work is foundational to trading
Questioning the dogma of rationality
Happiness, and the distinction between the remembering self and the experiencing self
The consumption of memories
The danger of not making peace with a loss
Bubbles and crowd behavior
Happiness research and public policy
Emotion, possibility, and probability
Hope and fear
Why optimism is the engine of capitalism
The influence of prospect theory
In this episode of Trend Following Radio:
The difference between the “remembering self” and the “experiencing self” and its impact on happiness
How the measures of happiness are being implemented into public policy
How the failure to accept one’s losses can lead to risk-taking in trading
How crowd behavior relates to economic bubbles
Why capitalism is largely driven by optimism
How behavioral economics have affected the trading world
The Amos Tversky and Daniel Hahneman Working Relationship
“Not making peace with a loss – this is the downfall of so many investors” – Tweet this Daniel Kahneman quote.
MICHAEL: My guest today has been called the most important psychologist alive today. His name is Daniel Kahneman. He is the winner of the 2002 Nobel Memorial Prize in Economic Sciences. Prospect theory, for those of you in the trend following world. Behavioral economics, behavioral finance. He is the guy. He started it all, along with his partner, many years ago. I welcome him to my podcast. I hope you enjoy.
MICHAEL: I was looking at your career, looking at all the research and findings, everything behind what you’ve done, and obviously we’re not going to fill it in on this conversation, but at what point in your life did you start to realize that you were comfortable looking at the world, people, behavior, from outside the norm? When did you first realize that you were looking at things from a different vantage point?
DANIEL: That’s an extremely difficult question.
MICHAEL: I like to give the hard ones right out of the gate.
DANIEL: When one does science, of course, you publish things because you think that they’re new. What we didn’t see was how far our research would be taken. So we studied, Amos Tversky and I began our work by studying judgment under uncertainty. Limited sort of problems of judgment. We worked on that five years, and we wrote an article at the end of those five years, in 1974, which was published in Science.
That article had a lot more impact and resonance than we had anticipated, and it was really in seeing that reaction that we realized that we had done something that was unusual, because people were reacting to it as if it were unusual. So it was somewhere between 1974 and 1980, we became aware that people were taking it as new, or were taking it as newer than we had taken it.
MICHAEL: Interesting. For me, in my world, the world of money and markets, your work is right there – for me, at least, from where I come from – is right there at the foundation. If people were to say to me, “Hey Mike, what’s the best way to learn about making money in the markets or being successful in the markets?” I would point them towards your work. I think it’s one foundational element that if people don’t wrap themselves around the internal themselves, they’re just not going to do very well, and I think you really – I don’t think you intended, perhaps, to have so many people on Wall Street be thinking fondly of your work, but it so happened that way.
DANIEL: Yeah. This all really came as a surprise. We had not expected it. I mean, there was going to be some reaction to the assumption that rationality into the dominance, the rationality assumption in finance and economics, it happened that we provided an instrument that people inside the discipline could use to question the dogma of rationality. It’s actually quite – it’s an interesting anecdote how this happened, and the reason our work had an impact, because it’s actually accidental, why our work had impact.
It had impact because of the way that we present our ideas, and we present our ideas by examples in the text of questions that people tend to get wrong. So the readers, who are not psychologists, readers outside the discipline, they read this and they face the demonstrationsthat work on them. And it’s when something works on you that you’re inclined to change your views about human nature. Merely getting data about undergraduates or some other people responding to questions does very little to people.
MICHAEL: Yeah, reading about others is one thing, but when you see the change internally on your own self, that’s when the magic can happen.
DANIEL: When you see yourself making mistakes or tempted to make mistakes, then the idea that people generally, people who are as smart as you are, are tempted to make mistakes, that’s a discovery. It makes it much harder for people to distance themselves from the findings, and I think that it’s this accident of format that caused our work to have the impact it did.
MICHAEL: I want to shift away from your early work to something that’s been near and dear to you recently, and that’s the subject of happiness. I mean, I’m sure it’s always been near and dear to you, but I would love for you to get into something that I think can help people regardless of what they’re interested in in their life, and it’s the idea of the remembering self and the experiencing self. That, out of the gate, might sound very academic to just a regular audience listening, but I think it’s a very important distinction that you’ve drawn. Why don’t you just talk about the experiencing self and the remembering self out of the gate?
DANIEL: Sure. There are two types of questions which you can ask people about how happy they are. We can ask them “How do you feel right now? What is your mood right now?” The self that answers this question, I call the experiencing self, because it talks about what’s happening right now. But when you ask people “How was your vacation? How happy were you during your vacation?” or “How happy have you been over the last year?” or “How satisfied are you with your life?”, when you’re asking those general questions, you’re asking for something entirely different. You are asking persons “how do you feel about your life?” Now that you’re thinking about your life, how do you think about your life? How that makes you feel.
So how you feel as you are living and how you feel when you’re thinking about your life are two very different questions, and it turns out that you can measure subjective wellbeing in both ways by asking people to report on their experiences or by asking people to think about their life and evaluate it, and different factors turn out to be important for experience and for life evaluation.
MICHAEL: But there’s quite a bit of confusion between the two. For example, I think you had a story about taking photographs on a vacation.
DANIEL: Yes. We seem to be planning our vacations; in many cases, we plan our vacations as constructing memories for use in later consumptions, and photographs are symbolic of that. But in fact, my argument has been that if you look at it in terms of how much time people spend consuming their memories, then that is a negligible amount of time compared to the amount of time that they spend having experiences. And yet we put a disproportionate amount of weight on the consumption of memories.
MICHAEL: Well, I’m sure you’ve observed this; you watch young people today, everyone’s got a smart phone, and it’s a constant taking of pictures of themselves, called “selfies.” It seems like instead of living and experiencing the moment, everyone is trying to capture an artificial moment and capture a memory, but the experiencing is not there. I don’t know – you’ve probably noticed this yourself.
DANIEL: I don’t do that, but that’s certainly – the ability to record so many things as they are happening to you must be changing the experience of life, because you are evaluating your experiences as future memories. And in a way, when you’re taking pictures of what you see, you’re adopting a different stance on the experience itself. Certainly, this is having an effect; what effect it has, at least, I don’t know. I haven’t analyzed it.
MICHAEL: Yeah, I don’t know what’s happening there. It doesn’t seem like it’s necessarily good or bad. It’s all relative. But I’ve only got you for a short amount of time, and I want to jump to a couple different areas that I think are really important to my audience, and some very strong thoughts that sound very straightforward, but I think – for example, a quote of yours that I’ve seen: “A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.”
Now, that can have meaning in far different fields, but in my world of trading, of finance and money and Wall Street, not making peace with a loss – this is the downfall of so many investors. And here you’re coming at it – I don’t imagine you were thinking through some of that work with investing and trading in mind, but it’s foundational. I mean, every great trader knows what you just said, that’s like written on the wall in some form or another.
DANIEL: Of course, we weren’t thinking specifically of investors, but it turns out there is research that demonstrates this. We know about traders, how they trade in the course of a day, and if they’ve been losing, they take more risks later in the afternoon. So that seems to be – the idea if you haven’t made peace with your losses, that means that you are trying to make up those losses. That tends to make you risk seeking, and we do see a lot of evidence for that.
And it probably is costly to traders. In the extreme cases, traders who trade so much that they can’t make peace with their losses; some of them get caught up in cycles of fraud and they become rogue traders. But those are the exceptions. But traders who are not rogue traders do tend to vary in risk seeking depending on the history of what’s happened to them during the day or during the year.
MICHAEL: Let me shift slight gears on you and talk about bubbles and crowd behavior. Generally, it seems – I know your research goes there, but that when people get together in crowds, the decision-making changes.
DANIEL: Well, yes. What we see is – and that is probably, ultimately, it’s biological. It’s following other people. When you see a lot of people running in one direction, we are by and large wired to run in the same direction. Now, a few very clever people will run in another direction, but the majority of us, when we see the herd moving one way, we move with it. That has large consequences, of course, on market behavior.
By and large, what it causes, it causes people individually to do far less well than the markets than they should, because they tend to come in too late when the market is rising. People’s timing is way off, and as a result of trying to follow the herd, they do much less well than they would do if they were basically adopting a policy and sticking to it.
MICHAEL: Is there anything else you’d rather be doing in your life than this? I look through your work and the findings, and I just imagine you’re terribly passionate about what you do.
DANIEL: Yes. And I do other things. I’ve retired from my academic career, and I now do consulting, which I enjoy just as much as I enjoyed science. It’s been a fun career, and the topic has been fun. When I started out this line of research like 45 years ago with Amos Tversky, this was sheer fun, because he was a very funny person with a lovely sense of humor, and we were laughing all the time. We laughed for about 12 years doing our research.
What made it funny was that we were studying our own biases and our own mistakes. Our point was not that people are stupid, because we never thought that people are stupid, and we never thought that we were stupid. But it’s our own mistakes and intuitions we were studying, and that must’ve been the best fun I’ve had in my life, those years of working on that topic.
MICHAEL: Yeah, because I assume the two of you were just, to some degree, off on your own island and just doing your thing, and the rest of the world was there, but you were engaged 100% in your endeavors. I’m sure that feeling must’ve been great.
DANIEL: Yes, it was. You know, we were friends, and for more than 10 years, I think, we spent about half a day just together talking, which was very unusual in scientific collaborations. So we were extremely fortunate. We liked each other’s company, and our topic was fun. Our topic was one that could be studied while having a fun conversation. That is, you examine your own intuitions, you raise puzzles, you see how the other responds, you develop theories and puzzles and intuitions at the same time. It was great to do.
MICHAEL: I watch leaders, often leaders making public policy, and near and dear to you is the topic of happiness that we just mentioned a second ago. But talk about happiness research in public policy. It seems like – I’ll give you the example of you and your partner at that time, and happy to go through this process, and you’re learning and you’re finding all these new things out. But it seems like today, it seems like so many leaders, when it comes to public policy, you don’t ever hear anyone talk about happiness. It’s just left out of the equation.
DANIEL: I think that’s not quite right, actually. The study of happiness is an official task within the UK government, and the UK government, the current coalition government, put in subjective wellbeing as one of the objectives of policy and one of the measures of policy. So trying to keep a happy population is rapidly becoming an accepted objective of policy. There have been major international commissions. This is a measurement of happiness, a formal measurement of happiness, is now routine and part of policy in the UK, in Canada, in many European countries. In Australia, things are beginning to move in this direction. And even in this country, there is serious talk of implementing measurements of wellbeing.
There are questions about how this is to be done, and whether we are ready for the measurements, and whether the measurement and our understanding of happiness is mature enough to base policy on it. So there’s room for debate about that. But that there is increasing recognition of the role of wellbeing in policy I think is beyond doubt.
MICHAEL: Let me go to a few more topics with you. Emotion. So much emotion in individuals driven by possibility and not probability. I think that’s probably intuitive, but it’s not necessarily, when it comes to decision-making, being driven by possibility versus probability. Leave us with some not great results, often, doesn’t it?
DANIEL: I suppose that what you’re talking about is hope and fear. When you’re looking at entrepreneurial activity, it is, we have argued, largely driven by optimism, so that when people take risks – at least, that’s my main understanding of risk, is that much of the time, when people take risk, it’s because they don’t know the odds that they’re facing. They’re actually deluding themselves. In my view of risk takers, they’re on the one hand loss-averse. They hate to lose. But on the other hand, they’re optimistic, quite often to a delusional degree, so that they don’t really know the true probability that they face of losing. That’s a combination that produces risk and risk-taking. But it’s mainly driven by optimism.
You can see that in entrepreneurs, you can see that in people with discoveries and are trying to bring them to market, you can see that in people who start small businesses. The average small business in the United States, there is 35% survival after five years, as I recall. But most people who start a new business assign themselves a probability of 80% or higher to be successful. So it’s that delusion that keeps them going. I’ve called optimism the engine of capitalism, because it is in that sense very beneficial to society. But many people would not be taking the risks they take if they knew the risk they are taking.
MICHAEL: Obviously, you’ve had a major dent in thought and people investigating the issues that you’ve laid out, understanding, believing, knowing it’s true. How much of a dent, though, I’m curious, do you think that something like prospect theory – how much of a dent has it really made in the sense – I mean, obviously, you’ve made a dent, but the acceptance? Because I look at, for example, you could look at the current U.S. equity market right now. I have no idea if it’s fairly valued or not fairly valued, but we can all observe, in the last 15 years, some quite fantastic bubbles and some quite fantastic busts.
DANIEL: I don’t really think that the advances in behavioral economics and behavioral finance – and I’m a customer and not a producer of that, and I’m really not an expert, but my impression is that very bright people are working on this, very bright people are trying to develop theory, but it’s early days of behavioral economics and behavioral finance.
When you say has it made a dent, well, the answer is clearly yes, because some of the major economics departments and finance departments in the land have behavioral economics and behavioral finance as a central part of their curriculum. The Harvard Economics Department, one of the best in the country, some of the major stars there are behavioral economists, and the best students are going there. Many of the best students are going there. So that you know that it has made a dent, because what graduate students are doing is telling you something both about the recent past and about the near future. The near future, there’s going to be a lot of behavioral economics going, because many very bright scholars are going into the field.
MICHAEL: I should probably clarify myself. I obviously was not trying to say it hasn’t made a dent, but I guess I was thinking more about the more established field of economics, the more rational side of the coin, where you’re coming at it from a different perspective. There’s always going to be that conflict between the two.
DANIEL: There is. There’s something almost funny about the last Nobel Prizes that were given, because the Nobel Prize in Economics was given to two people, both of them students of finance, with radically different ideas, so that you have Eugene Fama, who was a traditionalist and believes in the rational agent model, believes quite passionately about it and in the rationality of markets, and on the other hand you’ve got Bob Shiller, who speaks about irrational exuberance and doesn’t believe in the rationality of markets. So both of these currents are alive and well within finance. My sense is that there is a lot – that the younger people may be drifting in the direction of behavioral finance, but I’m not sure. This is an impression that I get.
MICHAEL: Can I get you to go back to your really early years for a moment – we’ve only got a few minutes left, but I would love for you to go back to as a young man, because I think when people listen to people that have had some achievement in their life and they’ve gone down certain paths, it’s always nice to look back and say “Can I relate to that person?” It’s very difficult to relate to somebody that maybe receives a Nobel Prize, but can you relate to that man as a young man?
I’m wondering if you might talk about maybe some of your early experiences, and I think there’s one experience that I believe was in France, and I believe it was with a German soldier, and you walked away from that changed.
DANIEL: Yeah, I can tell the experience. It was during the War. I was seven years old, 1941, in occupied France. France occupied by the Germans. They were beginning the measures against Jews. It wasn’t extermination yet, but they were getting ready. So the Jews were supposed to wear a star of David, the yellow star of David, and there was a curfew for Jews. I was a first grader or a second grader, probably, and I was staying with a friend, and I went past the curfew. So I put my sweater inside out and walked home.
Then near home, in a place I still remember – this was in Paris – there was a German soldier facing me and walking towards me, and he was wearing a black uniform, which I knew, though I was only seven years old, was a bad one because it was the SS that were wearing the black uniforms. He approached me, and I must’ve been shaking; I don’t remember every detail. But what I do remember is he stopped me, he called me, and he picked me up and he hugged me. I remember being terrified that he would see the yellow star inside my sweater as he was hugging me. And then he put me down and he opened his wallet and took out the picture of a little boy and showed it to me, and then he gave me some money and I went home.
It was the complexity of that experience – he was a man who was clearly ready and perhaps eager to kill people like me, but there he was, he has a son, he loved his son; I reminded him of his son. So it was the kind of experience of the complexity of human beings that has guided me. It has inspired, I think, a lot of my work. I’ve been curious about people all my life.
MICHAEL: Yeah, I think a lot of people might be envious when they – and I highly recommend them to take a look at some of your books – but it’s such a fun topic to be an observer of the human condition, just to watch people, to observe, and then to find things out that maybe you didn’t expect to see. That’s such a fun process.
DANIEL: Oh yes, that’s what I was saying. It has been a fun career.
MICHAEL: Well listen, I don’t want to keep you. You were kind enough to take some time out today. I will go ahead and point people to any place you might want – it might just be Amazon – to check out one of your books. I know you’re not trying to sell anything or promote anything. People can go check out Thinking Fast and Slow, is one book. I know there’s quite a few.
DANIEL: It really is the only one that was written for the public, and it’s still there. It’s actually on the bestsellers list. It has been since it was published, I think. So it’s easy to get. It’s $2.99 on Kindle. I don’t know why Amazon sells it like that, but that’s how they sell it. Anyway, that’s the book in which I told the whole story of my research and related research with other people. It’s not an autobiographical book. It’s a book about thinking and decision-making.
MICHAEL: Well, I love it. I love the topic. I think it’s so foundational to my audience, and I still think there’s probably some people out there that they say, “Mike, you’ve gone off the deep end. Why does this gentleman at Princeton – what is the relevance here?” I think some people just don’t get it, but there’s quite a few that do, and I think they’re appreciative to be turned onto new ways of thought and thinking. I appreciate all your work, and I appreciate you taking the time today.
DANIEL: Thank you very much for having me.
MICHAEL: Take care.
If you want to learn how to be a trend-following trader, the first place to go is trendfollowing.com. My firm can help you with educational, research, and systems trading packages to get you started immediately. Take advantage of my 15 years of experience. Take advantage of all the insights that I’ve accumulated and put into one research and educational package. These are systems that you can use immediately to start making money. Once again, go to trendfollowing.com.
I have just started my trend following journey. I had discovered this method in trying and failing for years at forex although I haven’t lost more than a few hundred thus far. Naturally once I heard the term trend following I immediately had an Aha moment. I am a regular or less than regular 30 year old uneducated guy. I have spent most of my life though learning about everything. I have taught myself a lot over the years so I’ve always known I could beat the market. Being a poor person has left me with little or no capital to make any realistic gains and when I have hear comes all the shit over data and news, and wiped me out. And every time I get mad at my self for not performing to my own standards which I see as my potential. I am writing you this letter because I have found myself in desperate times for a number of personal reasons, but in discovery of trend following I have found my way even if it takes me years. I have listened to almost everyone of your podcasts! and consumed as much information I can from anywhere I can. I would like to thank you for giving all us poor people a free opportunity to learn not for the magic bullet buy here sell there but for the general idea and the wisdom of saying see what you can do. I am currently trading forex with this method do to my limited capital and my ability to leverage. Whether I am successful or not time will tell but I’d like to thank you for everything you do basically for free and if I do make it I’ll have to say, “Michael Covel showed me the door, I just walked through it.”
Thanks,
Adam
Adam, thanks, but no more calling yourself poor. Poor is temporary, in mind and wallet.
My guest today is Tom Basso, the trader most famously known as “Mr. Serenity” in Jack Schwager’s “New Market Wizards”. Basso, now retired, was a stock and commodities trader who was president and founder of Trendstat Capital Management. He is the author of two books, “Panic-Proof Investing” and “The Frustrated Investor”. Basso became a registered investment advisor in 1980, a registered commodities advisor in 1984, and was elected to the board of the National Futures Association in 1998.
The topic is Trend Following.
In this episode of Trend Following Radio we discuss:
Location independence
Making sure trading doesn’t take up your entire life
Stoicism
Trend following in the emotional arena
Mental exercises
The psychology of trend following
The “observer self”
The mental aspects of success
The importance of being able to lose small amounts of money
Why trend following does so well when the black swans hit
Basso’s daily routine and the importance of routine in daily life. Covel and Basso also go through listener questions such as whether Basso would make the same trading decisions that he did from the start
Money management v. trading
Tinkering with current systems
Knowing when it’s a regular drawdown v. something really going the wrong way
Whether Basso is a one-system kind of guy v. multiple systems
In this episode of Trend Following Radio:
How to use mental exercises to improve yourself as a trader
Why the tolerance for losing small amounts of money can make you almost invincible
Tom’s daily trading routine: how to ensure you don’t spend the whole day making trading decisions
Why understanding strategic planning is key to being a successful trader
Trading for clients vs. trading for yourself, and the regulations that go along with that
Understanding the difference between a normal draw down vs. something really going wrong
Separating facts from opinions, and why it’s important in trend following trading
Listen to this episode:
Listen to this podcast on iTunes. (Please leave a rating!)
My guest today is Dan Ariely, a professor of psychology and behavioral economics at Duke. He has given great TED Talks with millions of views. Covel and Ariely discuss irrationality and rationality on today’s show, including how we make decisions (with often poor processes).
The topic is his book Predictably Irrational: The Hidden Forces That Shape Our Decisions.
In this episode of Trend Following Radio we discuss:
The irrationality of fundamentals in equity markets
The wisdom of crowds, constraints and where else our money can go
The awarding of the Nobel Prize to professor Shiller and Fama–two famed professors with very different outlooks–and whether it’s irrational or not
Macroeconomics vs. microeconomics
Lessons learned during his life-threatening burns
Why people lie
Why the freedom to do whatever we want and change our mind is the shortest path to making bad decisions
How 2008 became a constructive tool for Ariely
Why Bubbles are some of the most imprecise factors out there
Ben Bernanke
In this episode of Trend Following Radio:
Why many of our decisions are actually irrational
How the wisdom of crowds is often wrong
Macroeconomics vs. Microeconomics
Why people lie and cheat
How the freedom of choice relates to bad decisions
[toggle Title=”View Full Transcript”]MICHAEL: Today on the show I have Dan Ariely. He is a professor of psychology and behavioral economics at Duke. He has some great talks on TED; millions of people have watched his talks. His book, a bestseller, was called Predictably Irrational. I love the way Dan thinks. Enjoy this conversation.
So Dan, I’ve got to ask you out of the gate, you’ve got to have way too much fun in this career of yours.
DAN: I am having lots of fun.
MICHAEL: Seriously, this is not fair. You get to observe the world and say, “Well gosh, everyone looks at it this way, but are they really thinking rationally, or irrationally?” Quite fun. I’m jealous.
DAN: Well, you’re welcome to join us.
MICHAEL: Let me ask, let me jump right in. My world is somewhat in this Wall Street world, this trading world, and I know a lot of your work has crossover appeal, so to speak. So here we are, right now, equity markets all-time highs, in the Federal Reserve we all trust. It looks pretty rational to me, even five years removed from the great crisis – and I want you to talk about that, too, the lessons, how that helped make behavioral economics more to the forefront – but here we are right now at all-time highs. Everything looks pretty rational. Just trust the system. What could go wrong?
DAN: Yeah, we’ve been in this situation before, no?
MICHAEL: Well, yes, this is true. But how do you look at it right now, from your perspective, your lens?
DAN: There’s a couple of questions of where the value of the S&P 500 or whatever index you want to choose, where is it coming from? The moment you believe that it’s rooted in deep asset values, then you can have a rational story for it. But we know that nobody really calculates the value of companies based on their P&L and based on their assets and so on.
The other theory you could have is you say “Oh, it’s the wisdom of crowds. There’s so many small people in this field, everybody’s so intelligent, everybody knows so much, and the average of their opinions are so accurate and precise, this has to be correct.”
Or you could say there are a ton of cases in which lots of people are wrong. And not only that, there’s a ton of places in which people think short-term and not long-term.
And then there’s another issue, which is constraints. If you think about all the money in the markets and you say “Where else could this money go?”, and if it has nowhere else to go, then what could the markets do but appreciate? But not because the fundamentals are better, not because the outlook is better, not because it’s a long-term discounted value for the future, but just because of current constraints.
I think if you look at those four explanations – people value stocks seriously, everybody else is really smart, then you say everybody could be not so smart and just following the herd, and money has nowhere to go – for me, the last two explanations are much more appealing, and I think there’s much more truth to the problems with the markets. Now, of course, if the markets are high, you might want to participate in the joy of the markets increasing, but it doesn’t mean that fundamentally, it’s rational.
MICHAEL: Dan, when you look at this – I guess this spring/summer, when they made the announcements – so here you are, you’re in this world where the word “rational” and “irrational” has become so much a part of your daily life, and then I see the Nobel Prize Committee hand out the Nobel Prizes to two very smart men, but on very different sides of the spectrum. It just seems to add to the irrational aspect. I don’t know how you viewed that, the awarding of prizes to Professor Shiller and Fama, and very different outlooks on the world.
DAN: Yeah, I think it was really a hoot to see them both coming. Fama, of course, is one of the big believers in the rational market and that the markets are rational and perfect and ideal and so on, and Shiller for a long time has basically – he was one of the early predictors of the financial crisis in terms of housing markets, and he talks about bubbles and he talks about the fact that markets cannot necessarily get people to behave better, and that people are short-term thinking and so on.
I don’t know if the Nobel Committee was known for its sense of humor or they thought that was a joke, but this was not the forefront. I think they really wanted to give it to Shiller, if I had to speculate. I think if they had to strengthen – I don’t know what the Nobel Prize is for, but if it’s looking forward and saying “Which part of economics do we want to strengthen, and which part of the prizes do we feel embarrassed that we’ve given before?” – giving prizes in the past for derivatives and so on – I think they really should’ve given it to Shiller, but it was probably too difficult for them to undermine economics to such a degree. At the end of the day, the people who are giving the Nobel Prize in economics are connected to economics, so they probably don’t want to spit in the well they’re drinking from too much.
But I think that this is a time to really question economics in a deep sense, and I don’t think we’ve done enough of that.
MICHAEL: Let me let you elaborate. When you say question it, most people look at the TV and they say, “Look, there’s Ben Bernanke; he’s the head of the Fed; the markets have gone straight up. He’s a very smart man, and he studied the crashes in ’29, ’30, whatnot, and our markets right now are doing great. Why should I not trust this economist?”
DAN: Most of my work is in microeconomics. I look at individual behavior. Macroeconomics, of course, is much more complex, because macroeconomics depends on so many other things. And the truth is, we understand macroeconomics very little.
But think about something like bubbles. Bubbles are one of the most predictable phenomena we have. You could take 20 people, you put them in a room and you sell them some asset – it could be a stock, it could be a fictitious asset, whatever it is – and observing bubbles is the first thing that you see. It’s really incredibly easy. And it’s hard to know from within a bubble whether you’re in a bubble or not. You can only know at the end of the day.
Look, if you look at macro theories, these are nice theories, but at the end of the day, we have very little evidence for them. If somebody asked me to build a bridge based on a theory that is at the quality of macroeconomics, I would be incredibly worried. And we’re building, of course, much more than bridges. If somebody asked me to go into surgery based on a theory that was as sound as the theories we have on the relationship between what the Fed is doing and what the real economy is doing, I would be incredibly worried.
So we have this general explanation that might capture some of the variance and some of the essence, but they’re so imprecise that I think we should be incredibly leery of them. This is a little bit the question of how do you want to bet.
You know what’s called Pascal’s Wager for the existence of God? Basically, the idea is that if you feel God doesn’t exist, don’t worry about it. But if you think there’s 0.0001%, a tiny percent that God exists, you might as well behave as if you believe, because the penalty, multiplied by infinity, if you go to heaven or hell, is so big that it’s worth it.
I think the economy is a little bit like that, that we are taking these bets, and the payoffs are very, very non-symmetrical. If Bernanke is right, we’re going to do okay, but if he is wrong, we’re going to really, really pay for it for a very, very long time. You saw the amount of financial devastation we had by these mistakes. I think it way outweighs the benefit that we got from taking this risk.
So I think we need to understand how economics is important for the way we function. We need to study it to a much higher degree. We need to understand it, and we need to have something like an FDA procedure for approving which economic theories we’re going to let dictate our lives. In the same way that before, you put a medication up and say “Yes, let’s give people this medication or this hip” or whatever it is, I think the same thing should be held for theories, and before we let them rule our lives, we should make sure that they pass some threshold of proof that they’re actually useful for us.
MICHAEL: Go back to the fall of ’08. Why, from your perspective, your world, your work in behavioral economics, why did 2008 become such an instructive tool for you?
DAN: I think there are two reasons for that. The first one is that I think for me, the financial crisis was really not about the housing market. It was a financial crisis due to conflicts of interest. I’ve done lots of work in conflicts of interest, and it turns out that when you see bad behavior – you see a CEO behaving badly, or some banker, something happening – people tend to point fingers and say “These are just bad people. We have good people, we have bad people. We are good; some other people are bad. And as long as you eliminate the bad people, everything would be okay.”
But we’re finding that this is not the case. We’re finding that lots of people can bend reality to a small degree, look at things from their perspective, and be biased in their worldview. Interestingly, this is something that every sports fan knows very well. Every sports fan knows that if a referee calls a call against your team, you feel the referee is vicious, blind, stupid, something. You can’t help but see the game from your subjective, desirable point of view.
And the same thing happens in other places. If I gave you a ton of money to see mortgage-backed securities, of course you would see them. And I’m not saying you would lie; you would just see them as better than they are. There’s lots of other things that make it even more likely. You don’t see the victims, everybody else is doing it, and so on. I think this is important because the conflicts of interest in Wall Street are just tremendous – I’m sure you know it as well as everybody in the field – and we haven’t really done anything to fix that.
The second thing is that I think it was a very different crisis than the .com boom, for example, and bust. The reason is in the .com, you could tell yourself that “I should’ve seen it.” You could tell yourself, “Yes, you know what? It was overvalued and over-hyped, and I shouldn’t have got into it.” I think 2008 feels much more like a conspiracy to people. It feels much more as daytime robbery, and because of that, it created tremendous loss of trust. This is tremendously sad, because if you look from 2008 to now, the markets have done – we had this tremendous variance.
But what happened is that lots of people, as things were getting down, lost their trust in the market and got out, and a lot of those people are people that needed that money for retirement. They said “I can’t risk it anymore,” they got out of the market, and actually we’ve not enjoyed any of the increases.
So it’s been a tremendously sad sequence that eroded the trust between people and banking in a very sad way, and I think it’s really terrible that none of the fixes have really aimed at rebuilding trust. I think that until we rebuild trust – and the markets could go on, but the individuals who really need these institutions are not going to get any value from them.
MICHAEL: It seems like instead of rebuilding trust, it almost seems like the government has offered a bribe, and the bribe is “Hey, don’t mind that you don’t receive interest income anymore; don’t mind that derivatives were a huge part of 2008. Don’t mind that Bear Stearns and Lehman Brothers went under, but we saved Goldman Sachs and Morgan Stanley. Don’t mind any of that stuff that a rational person would probably observe and say ‘hey, what’s going on?’ Just look at the stock market. It’s going up. Trust us.”
DAN: It’s really terrible. And all the fines the government is giving to financial institutions I think are actually not helping, because they just seem like cover-up. “Okay, so these people are stealing lots of money and then they get to give some of it away.” The story about how much Goldman Sachs got back from its investment in AIG, I think is now going to go away for a long time.
The level of misuse and abuse of trust and funds I think is going to hurt the American people for a long time. It’s not going to hurt the bankers, because again, there’s some money that has to go into the banking system, and they just take their share. Basically imagine that there’s some money in the world that has to go through banking, and every time it does, you get to get your 1% offer. It’s a really good business to be in if what you want to do is maximize your profit.
MICHAEL: I think J.P. Morgan made money 63 out of 63 days in the first quarter. I want a part of that business.
DAN: Yep. And the other sad part of it is that the government has made it more difficult to start new banks. I think that, at least for me, there’s a realization that banks are more important than I thought they were. I always realized that banks were important, but I think now I realize they’re even more important for the functioning of society. When lending slowed down and so on, the economy basically had such difficulty.
But there’s no real competition between banks. I mean, think about it: if you had this model of the world, of supply/demand and competition, and you said companies should basically compete, and they compete so fiercely until the production cost and the revenues are almost equal. So you would basically say – this is the logic for competition – you say you increase competition, everybody’s competing for the consumer; the companies would have to reduce their price to be competitive, otherwise the consumer would switch. And eventually what will happen is companies will charge people their production costs and they will make almost no money. Company 1 is selling you a widget, Company 2, they compete and so on.
In all the industries in the world, I think the industry that fits best this theoretical prediction is banking. It’s really easy to switch from one financial institution to another, they’re basically all selling the same thing, there are many of them, they are spending all their time competing. You would predict that their profitability would go down to zero, but that’s not really what we’re seeing. They make a ton of money, which of course gets us to question very, very deeply this model of competition, and is this really a free market?
And I think it’s not. I’m not talking just about the interest rates fixing and so on and the collusion that is going on. That’s of course illegal. But even in the level of non-collusion, or non-explicit collusion, I think there’s all kinds of things that are just very, very rotten in this industry.
MICHAEL: Building on your point, though, about the banks, if you look at another industry, let’s say like airlines – and I was on flights quite a bit this year – generally what we see over the decades is improvement in airline safety. We learn from our mistakes and things get better. And that doesn’t happen in the banking world, for whatever reason. We can look at those reasons really fast – power, money, politics. But banking doesn’t get better; it just seemingly gets more to the edge of the cliff after each crisis.
DAN: Yeah, and I think there is a couple of good reasons for it and a couple of terrible reasons. The good reason is that it’s really hard to learn in banking. Think about an airline. In an airline, of course, if something catastrophic goes off, people get injured, people die, and the airline learns very quickly. It’s a singular event; you could put your finger on it and you can figure what it is. But also, things that slightly go wrongly, you can figure out what has gone bad and you can learn from it.
In banking, it is not really clear how you learn. Like what lessons can you learn? If you believe that the world is rational and you believe that everybody else is doing the same thing, then it’s really tough to learn about mistakes, because you said, “Oh, this is just the rational thing to do. This is what should’ve happened. This is a reflection of all the knowledge in the world. Let’s keep on doing this.” The learning cycle is very, very tough. Think about it: under what conditions would you figure out that the investment strategy you had was wrong?
And then the other thing is that – think about something simple, like going through a red light. Imagine that you think that going through a red light has a 1% chance that you will die and 99% chance that you will go safely, and one day you decide to take the risk. We know it’s a 1% event. You went through it and nothing bad happens. What do you think the next day? You say “Oh, it was a 1% chance and I luckily passed it”? Or do you say “Oh, it must mean that the risk is really half a percent,” and let’s do it again and again and again?
So there’s a vicious cycle that when you don’t know the probabilities very well, you just estimate them, and they are low probabilities, the more you experience something, the more it gives you the wrong feedback, as if the probability is actually lower. So people could take tremendous risk, if you think about the London Whale or things like that, and not realize the risk that they are taking.
And because we don’t really understand risk very well, basically they’re in a psychological notion that they’re actually taking a reasonable risk, when in fact they’re taking a tremendous and highly devastating risk, and once they get a huge failing, of course, it’s too late to learn from it. It’s like an accident that happens.
So I think that if you think about the environment and you say what environment can people really learn from, and what environments are there that make it very, very tough to learn, I think the marketplace is a place where it’s really tough for people to learn. And because of that, by the way, I would regulate it to a much higher degree, in the same way that we don’t let people drive through red lights because we say people are going to take unreasonable risks and they’re not going to think about it correctly. I think the same thing applies to many activities in the stock market.
MICHAEL: Dan, since you brought up red lights, it’s actually an amazing system of people where you would think they might not respect each other, but since there really isn’t a lot of traffic laws, so to speak, it works with this chaos. I don’t know if it would ever work in America, but it works there. It’s amazing.
DAN: And of course, it’s a question of how fast the cars are and what else do they do and how they drive and so on. Nobody really wants to die, but do people naturally take too much risk? In the U.S., some states regulate that you can’t text and drive. You know what happens in those states? The amount of people dying and getting injured from texting and driving is increased. And the reason is that because once this legislation was passed, people started texting below the wheel rather than above the wheel, making it much, much more dangerous, and killing themselves in higher frequency.
MICHAEL: Let me shift out. We’ve had this great macro conversation about banking, but I want to shift into some of your wheelhouse, because your world is far beyond just Wall Street, and behavioral economics, this is the everyday life study. There’s a quote that I saw from you, and I want to paraphrase a little bit; it says “the freedom to do whatever we want and change our minds at any point is the shortest path to bad decisions.” So this great American ideal of all this freedom and being able to do what you want and change your mind – but in actuality, it’s not that great for making good decisions, is it?
DAN: It is not, and this is because temptation is really a devastating force in the economy, and temptation is only getting worse and worse. Imagine two worlds; imagine a world in which I layer your desk every morning with fresh donuts and give you a choice to choose whether you want to eat any and how many, versus a world in which I ask you one time whether you want this every day or not. The choices, making everyday choice, is incredibly damaging, because every day we could say “Oh, it’s just for today and it’s just one time and it’s just this thing and it’s really tempting.”
This is, by the way, why financial education doesn’t really work. There was a recent meta-analysis on all the financial literacy programs ever being created, showing that they basically don’t work, that the best of them improve financial outcomes by 6%, which is very small, and it goes down over time, and it’s worse for the poor. The reason is that you can know something in principle, but acting on it every time is really, really tough.
We are designing the world that we live in, and we can design the world for people to make better decisions, and we can design the world to make people make worse decisions, and I think often we design the world to tempt people at the moment and get much worse access.
MICHAEL: Yeah, tempting at the moment. That feels like a very apt description of current day life. While we’re talking about current day life, why do people lie, Dan?
DAN: Why do people lie?
MICHAEL: Why do people lie?
DAN: Of course, there’s the simple ones, which are the white lies. You know, “Honey, how do I look in that dress?” kind of stuff. But what we find in the experiments is that people don’t lie because they do some kind of cost-benefit analysis and say “what do I stand to gain, what do I stand to lose, this is my long-term interest.”
People actually lie because they give them something at the moment. At the moment, and they only do it under the condition that they can rationalize the lie. So when something is rationalize-able, where you could say “this is actually for the benefit of the group” or “everybody else is doing it,” the tendency to do so is much, much higher. There’s a contrast on the difference between downloading illegal music from the internet and going to a restaurant and escaping without paying.
The difference between them is in one of them, you would feel bad about it; in the other one, you would not. What makes you feel good and bad is not about the probability of being caught, and it’s not about the size of the punishment. It’s about your internal feeling that something is reasonable versus not. It’s your internal ability to rationalize. This is the root of all dishonesty. By the way, this is not true for psychopaths, but if we take psychopaths out of the…
MICHAEL: If we take psychopaths out of the equation, we’re all right.
DAN: Because we can rationalize, but the psychopaths are very, very different. But the non-psychopaths, we all lie and cheat to the extent that we can rationalize it and explain why this is actually okay, even when it’s not.
MICHAEL: Hey listen, as we wrap up this morning, I want to ask you a couple different questions, and I think they’re interrelated. But I want to really know how you – obviously, to go in your path, very curious; you like to find out how things work, and you’ve probably been like that since a young man, I’m guessing. But I also know you had a fairly devastating injury as a young man as well, burns over a large portion of your body.
I wish you could maybe explain how you came into this field of behavioral economics – and you’re one of the leaders in it – and then maybe also, as a dovetail into that, explain some of the lessons that you came through, maybe some of the “aha” moments that you had going through your recovery process.
DAN: When I was a burn patient, there was lots of things that I saw that were done in what I thought were a wrong way, all the way from how they treated some patients to some treatments to how they used to remove bandages from burn patients. I saw this tremendous amount of misery, on my part and the part of other patients, and I had a desire to try and get some kind of basic understanding of how this should be done. It struck me as incredible that a lot of doctors were working on their intuition about what was right and what was wrong. But of course, they would never, in my situation, it wasn’t clear to me that they had the right intuition.
When I started studying this systematically, when I went to college some years later, I learned that often they had the wrong intuition. I’ll give you an example from this week. We are now working on a project on how doctors communicate really bad news to patients. And you know what? They do it in a terrible, terrible way. They don’t understand what the patients understand and what the patients don’t understand, and they give them news in ways that are really not very helpful and uninformative.
So there’s lots of things like that that I’ve been very interested in trying to fix. I think that’s also what’s driving me in behavioral economics. I look at all the things that we’re doing badly and I say “Can’t we do better? Can’t we just learn a little bit more, have some basic principles that tell us how to do this and do them better?”
When you look at the physical world, it is truly amazing what we’ve built. We’ve built buildings and cars and technology. It’s unbelievable. But when it comes to the world of understanding human nature, that has to do with how do we create educational programs and how we teach people and how we create risk and how we understand savings and so on, we haven’t really progressed that much. And I hope that we will be able to learn much more about this and make the world a truly better place.
MICHAEL: Hey, Dan, listen, I appreciate your time today. Where’s the best place that people can go and reach out and find out more about your work, maybe you – and I think there’s some online courses that anybody can take? Where can people go?
DAN: My blog is DanAriely.com. The course will probably start again in March or February. It’s an online course, open to everybody, and there’s lots of other information on my blog.
MICHAEL: Hey Dan, thanks. I could pick your mind all day. I know you don’t have all day, but I love your insights, and I appreciate your time today.
